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Aswe have argued in this column, the persistent bad growth mix since the creditcrisis - high fiscal spending at a time when productive private investment hasbeen declining - is at the heart of the challenging macro environment for India.
This bad growth mix has been steadily taking down India's potential growth rate(growth at which inflation does not accelerate) and we believe that this is nowunsustainable, as evident from the stretched macro stability indicators of a highercurrent account deficit, persistent high inflation and tighter inter-bankliquidity.
As we have argued in this column, the persistent bad growth mix since thecredit crisis - high fiscal spending at a time when productive privateinvestment has been declining - is at the heart of the challenging macroenvironment for India.
These macro imbalances will eventually be corrected - ideally, this should bedone efficiently by reducing public expenditure - however, given the lack ofpolicy action thus far, we believe that a suboptimal market-induced correctionis underway. The ideal method to correct these imbalances would be forpolicymakers to change the growth mix from fiscal deficit induced,consumption-led growth to policy reform-driven, and investment-led growth.
Specifically, in our view, policymakers should take steps to lower publicspending, including subsidies, and simultaneously introduce steps to reviveprivate investment sentiment. Steps to control public expenditure will help toreduce the macro risks and eventually bring down the cost of capital. The stabilizationof macro imbalances, plus a lower cost of capital and a boost to investment,will help build a virtuous cycle of investment growth and GDP growthacceleration.
This would help to increase long-term potential growth without further fanningmacro imbalances. Unfortunately, policymakers have continued to delaymeaningful action to address the unsustainable bad mix of growth. The continuedreliance on an expansionary fiscal policy has already led to widening ofcurrent account deficit, which at a time when capital inflows are slowing hasinvoked the pressures of managing the balance of payments deficit.
The cost of capital, which will remain higher for longer in this scenario, will weigh further on investment growth. This market-induced correction would be a suboptimal outcome as lower investment would mean lower potential growth. As the limits of the bad growth mix have been reached, we think that GDP growth is likely to face another leg down. We expect the India economy to grow by a weak 6.3% in the financial year ending March 31, 2013.
The macro challenges and the lack of scope for a counter-cyclical response will
mean that we are likely to see a deeper and longer growth slowdown ahead.
Indeed, we expect growth to remain in the 6.0-6 .5% range for six quarters in a
row (from October-December 2011 to January-March 2013).
As we have highlighted previously, a weaker growth trend lasting for more than
3-4 quarters could have adverse implications on the domestic banking sector as
the ratio of non-performing assets tend to rise with a slowing growth
trajectory, which then leads to risk aversion in the domestic banking sector.
While we do expect RBI to ease monetary policy in response to a slowing growth
trajectory, we believe that it would be difficult to lower the cost of capital
effectively in the near term as persistent balance of payments (BoP) stress means
that the RBI will face the impossible trinity of managing the exchange rate and
controlling interest rates when capital flows are volatile.
This article is originally published in the 'Economic Times', dated 25th May, 2012, written by Chetan Ahya. He is associated with Morgan Stanley as the Asia-Pacific Economist.
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